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The problem with a fractional reserve system sponsored by Central Banks is that it increases geometrically (that word again) the chances of something going horribly wrong and a large number of banks going bankrupt. If this would to happen, all the customers of that bank would suffer significant to total loses. How significant? How total? We will explore the answers next.

Classic Bank Default

This type of default does not happen very often. Actually now days it is pretty rare. It usually takes place when a government takes drastic action such as freezing bank accounts of most population or some other sort of idiotic emergency measure. This has happened in Argentina in the recent past. It will happen again, it is just a question of when.

The result of such measures is to be expected. People panic. And what do panicking people do when they believe their money is at risk? They go to the bank and demand their cash now. One small problem. The bank does not have the cash. It isn’t that the bank currently does not hold sufficient bills; it is that it does not have sufficient “reserves” in its account at the Central Bank to go there and exchange them for physical bills.

Voila! Instant bankruptcy. This is called a Bank Run because all the clients run to the Bank to get their money out.

As you may have noticed, the issue is that the bank lent out more money than what it actually had in “reserves”; the fact that the bank lent money out is not an issue. It is the fact that the bank is operating under a fractional reserve process that makes this type of situation fatal.

In the case of a traditional Bank where safekeeping and investment deposits are segregated, a bank run would have some effect but it would not be deadly. All the people who were entitled to instant redemption would have their money redeemed since all their money is actually in the bank. Those who deposited with the intention of investing, will have their money invested by contractual agreement with the Bank and hence had no right to instant redemption.

Other Bank defaults

There are many other ways in which Banks can go into bankruptcy. Let’s take a look at some of them.

Preemptive strikes

Let’s assume that for some reason Bank A is suddenly considered insolvent by the public. This will probably trigger a bank run against Bank A and not any other banks. But the other banks do not know this, so, they take preemptive action and decide to increase their amount of “reserves” just in case people start to doubt their banks by association. How do they increase “reserves”? There are many ways.

  • They may stop lending
  • They call up the loans and not renew them
  • Sell assets

Net result? Money is shifted from the market and into “reserves” (i.e. Banks accounts in the Central Bank). This instantaneously leads to financial crises, recessions and depressions because most companies operate on credit. It is normal for companies to have investments that take time to pay. If a bank calls in the loan, they simply cannot pay it and go instantly bankrupt.

Contagious processes

Let’s take a look at this process:

  1. Bank A buys asset A1 (which trades in a Stock Exchange) and insures this asset against large drops in price with Bank B
  2. Bank B insured Bank A but at the same time, it purchases assets B1 (also trading in the Stock Exchange) and insures them with Bank C
  3. Bank C insured Bank B and at the same time, it purchases assets C1 (also tradable) and insures them with Bank D
  4. And so forth.

For as long as prices of assets A1, B1 and C1 remain more or less within a reasonable range, they don’t trigger the insurance. But let’s suppose that for some particular reason, only asset A1’s price drops significantly. This triggers the insurance from Bank B which needs to pay Bank A. The problem is that Bank B does not have the money. So, Bank B sells all its B1 assets, which triggers a drop in their price, which now triggers the insurance provided by Bank C. Bank B is counting with the insurance money to pay Bank A. But Bank C does not have the cash to pay the insurance, so Bank C sells their C1 assets, triggering the Bank D insurance… and so forth.

This is a chain reaction triggered not by the fact that Banks insured each other, but by the fact that they purchased all those assets with newly created fiat money. Hence, insurance payments are proportional to that money that they did not have in the first place!

This scenario is just one of many such possible scenarios. Economists call it a cross cascading default. This simply means that bank defaults run like a water cascade through a staircase, from one bank to the next one leaving only default through its path.

This can’t happen? It almost happened in 2008 with the Sub-Prime Mortgage fiasco.


Leverage is nothing new. It only means that through some sort of mechanism you control more money than you have. The idea is simple.

Simple market transaction:

  • Buy an asset by 100 Rupee
  • Wait until asset price reaches 100 Rupee
  • Sell the asset at 110 Rupee
  • Profit = 110 – 100 = 10 Rupee or 10%

Leveraged market transaction:

  • Buy an option to buy 50 assets at 100 Rupee each
  • Pay 10 Rupee for this option
  • Wait until asset price reaches 110 Rupee each
  • Buy 50 assets at 100 Rupee each (5000 Rupee)
  • Sell immediately 50 assets at 110 Rupee each(5500 Rupee)
  • Profit = 5500 – 5000 – 10 = 490 Rupee = 4900 %

In the first transaction the bank had to spend 100 Rupee to earn 10 Rupee or 10%. In the second transaction the bank had to risk 10 Rupee but made a 4900% profit!

Now you see why leveraged transactions are so appealing. It is possible to make large fortunes with small investments. The problem is that leveraged transactions are symmetric. For every person buying an option for cheap, there is another person selling that very same option. This second person is betting that the asset won’t go up in price and will pocket the money you paid.

But what happens if the asset goes up in price? They are forced to sell to the option holder the assets at the stipulated price (in this case 100 Rupee each). This means that they are buying at 110 Rupee and selling at 100 Rupee with a total loss of 490 Rupee!

Leverage worked against them in this case and they lost a large fortune for a very tiny profit. Now assume that this person selling the option is a Bank. Also assume that this bank has lent out all its money to the maximum allowed by the Central Bank through the fractional reserve system. When the time comes to buy the asset at 100 Rupee, they simply won’t have the cash! Which means that they will do as indicated above and:

  • Stop lending
  • Calling up the loans and not renewing them
  • Selling assets

Result? Instant economic crisis. To this we can add the Contagious process for a full blown crisis.


Central Banks have always catered to the Power Elite first and to governments to a lesser degree. But what are their technical goals? They are twofold:

  • To protect Private Banks against the Free Market through cartelization
  • Fund government spending

Let’s take a look at both goals

To protect Private Banks against the Free Market

We have explained before how through the magic of the fractional reserve system banks can create money out of thin air. A natural tendency for people is to be greedy; this translates to banking in the form of unlimited money printing. If private banks would be allowed to print infinitely, all other banks would follow suit because they would want to generate profits and would not want to be left behind when there is fiat money to lend. This would be catastrophic for the entire economic system.

Central Banks curtail this tendency through the imposition of minimum reserve levels in the order of 10%. Private Banks cannot easily print money beyond this point (technically speaking they can use leverage to achieve a somewhat similar result).

Even with the imposition of these limits, there still exist real Freeish-Market processes that can threaten a bank. In order to minimize these risks, Central Banks cartelize other banks (i.e. create an artificial monopoly of money). Never fear, the Central Bank is near… as a lender of last resort.

Lack of confidence

If for some reason there is a bank run due to lack of confidence, the Central Bank could step-in and lend newly created money to this faltering bank to avoid bankruptcy. Why would a Central Bank do so? Because this trouble bank may belong to the Power Elite or the Central Bank may not want to risk the run to spread to other banks or to avoid other banks from panicking and taking the financial system down.


A bank may get into troubles and may have to come up with cash fast. The bank may not have sufficient assets to sell or sufficient time to do so and must therefore make use of its reserves. But it a bank would to do so, it would be instantly in breach of the minimum reserve requirement. Therefore the Central Bank has the option to step in as a lender of last resort and lend new money to the bank and hence avoid bankruptcy.


In a Free Market, if a Bank A creates sufficient money out of thin air and a fair amount of this money is loaned out to a single client, there may be a problem. If this client spends this money and it is subsequently deposited into Bank B, this second bank will want to have the reserves transferred from Bank A. Unfortunately, Bank A does not have such reserves because it created money out of thin air. Without a power to force banks into a cartel and hence forcing them to accept each other’s receipts for money that never existed (e.g. checks) instead of “reserves”, banks would face a very high risk of bankruptcy simply by having very large clients… which are usually related to the Power Elite. This cannot be allowed to happen. Hence, Central Banks act as a sort of banking police forcing banks to accept each other’s receipts instead of reserves.

These are just a few ways in which Central Banks can protect banks and enhance the wealth of Power Elites all against the rightful punishment that a Free Market would impose.

Funding government spending

All Central Banks fund government spending one way or another. We have seen how these operations are carried on in our lesson Fiat Money For A Fiat Economy.

These two goals of protecting banks against due punishment and to fund government debauchery, are malevolent indeed because they do so at our expense. They do so by lowering the standards of our living.

Note: please see the Glossary if you are unfamiliar with certain words.

 Continue to Central Banks must go - Part 5


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